The Monetary Expansion Process From an Open Market Operation Can Continue Until

What is Open Market Operations?

An Open Market Operation or OMO is merely an activity performed by the central bank to either give or take liquidity to a financial institution or a group of financial institutions. OMO aims to strengthen the liquidity status of the commercial banks and take surplus liquidity from them.

Table of contents

• What is Open Market Operations?
  • Steps of Open Market Operations
  • Types of Open Market Operations
    • # 1 – Permanent Open Market Operations
    • #2 – Temporary Open Market Operations
  • Open Market Operations Examples
  • Advantages and Economic Targets of Open Market Operations
    • #1 – Inflation and Interest Rate Targeting
    • #2 – Money Supply Targeting
  • Conclusion
  • Open Market Operations Video
  • Recommended Articles

Steps of Open Market Operations

The central bank takes either of the following two main steps based on the economic conditions, which are known as Open Market Operations:

1. Buying government bonds from banks
2. Selling government bonds to banks

Let us discuss each step of open market operations in detail:

1. Buying Government Bonds from Bank

   When the country's central bank buys government bonds, the economy is usually in the recessionary gap phase, with big unemployment problems.

   When the central bank buys government bonds, it increases the money supply in the economy. The increased money supply decreases interest rates that cause consumption and investment spending to grow, and hence the aggregate demand rises. This, further, causes real GDP to increase.

   Thus, buying government bonds from banks increases the real GDP of the economy; hence this method is also called Expansionary Monetary policy.

2. Selling Government Bonds to Banks

   The central banks sell government bonds to banks when the economy faces inflation. The central bank tries to control inflation by selling government bonds to banks.

   When the central bank sells government bonds, it sucks the excess money from the economy. This causes a decrease in the money supply, which causes interest rates to increase. An increased interest rate causes consumption and investment spending to fall, and thus aggregate demand falls. This causes real GDP to fall.
   Thus, selling government bonds to banks decreases the real GDP of the economy; hence this method is also called Contractionary Monetary policy.

Types of Open Market Operations

There are two types of open market operations:

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# 1 – Permanent Open Market Operations

This is involved in the outright buying and selling of government securities. Such an operation is taken to have long-term benefits like inflation, unemployment, accommodating the trend of currency in circulation, etc.

#2 – Temporary Open Market Operations

This is usually done for the transitory the reserve requirements Reserve Requirement is the minimum liquid cash amount in a proportion of its total deposit that is required to be kept either in the bank or deposited in the central bank, in such a way that the bank cannot access it for any business or economic activity. read more or to provide money for the short term. Such an operation is done using either repo or reverses repos A Reverse Repurchase Agreement is an agreement between a buyer and seller that states that the buyers of securities who purchased any type of securities or assets have the right to sell them at a higher price in the future, whereas the seller is required to accept the higher price in the future. read more . A repo is an agreement by which a trading desk buys a security from the central bank with a promise to sell it later. It can also be considered a short-term collateralized loan by the central bank with the difference in the purchase price and the selling price as the interest rate on the security. Under the reverse repo, the trading desk A trading desk is a section within a bank or company that buys and sells securities such as bonds, shares, currencies, and commodities to facilitate their own or clients' trades in the financial markets, ensuring market liquidity. read more sells the security to the central bank with an agreement to buy at a future date. Overnight Repos A repurchase agreement or repo is a short-term borrowing for individuals who deal in government securities. Such an agreement can happen between multiple parties into three types- specialized delivery, held-in-custody repo and third-party repo. read more and reverse repos are used for such temporary open market operations.

Open Market Operations Examples

Let's understand the Open Market Operations Examples with the help of one more example:

• The Federal Reserve Bank (Central Bank of United States) purchased $175 million MBS from banks originated by Fannie Mae Fannie Mae, i.e., Federal National Mortgage Association is a United States government-sponsored enterprise (GSE) which was founded in the year 1938 by congress to boost the secondary mortgage market during the great depression which involves financing for the mortgage lenders thereby providing access to affordable mortgage financing in all the markets at all times. read more , Freddie Mac, and the Federal Home Loan Banks. Between January 2009-August 2010, it also bought $1.25 trillion in MBS that had been guaranteed by Fannie, Freddie, and Ginnie Mae. Between March 2009-October 2009, it purchased $300 billion of longer-term treasuries from member banks.
• As the Fed's short-term treasury bills matured, it used the proceeds to buy long-term Treasury notes Treasury Notes are government-issued instruments with a fixed rate of interest and maturity date. As a result, it is the most preferred option because it is issued by the government (therefore, there is no risk of default) and also gives a guaranteed amount as a return, allowing the investor to plan accordingly. read more to keep interest rates down. It continued to buy MBS with the proceeds of MBS that matured.

Advantages and Economic Targets of Open Market Operations

#1 – Inflation and Interest Rate Targeting

• The major target of these operations is interest rates and inflation. The central tries to maintain inflation at a certain range so that the country's economy grows at a stable and steady pace. The central bank takes this as a close relation with interest rates. When the central bank offers securities and government bonds to other banks and the public, it also affects the supply and demand of credit.
• The buyers of the bonds deposit the money from their account to the central bank's account, thereby decreasing their reserves. Commercial banks buying such securities will have less money to lend to the general public, thus reducing their credit creation capacity. Thereby impacting the supply of credit.
• When the central bank sells the securities, there is a decrease in the price of the bonds, and since bond prices and interest rates are inversely related, the interest rates rise. As the interest rates rise, there is a decrease in the demand for credit.
• When the central bank sells the securities, there is a decrease in the price of the bonds, and since bond prices and interest rates are inversely related, the interest rates rise. As the interest rates rise, there is a decrease in the demand for credit.
• When the central bank buys the securities, the cycle is reversed, inflation rises, and interest rates decrease.

#2 – Money Supply Targeting

• The central bank may target and control the money supply in the economy. The central bank tries to maintain adequate liquidity in the banking system. When it feels there is high liquidity, it tries to suck the excess liquidity by selling bonds and vice-versa.
• E.g., the Reserve Bank of India conducted two open market operations (OMO) purchase auctions of Rs 10,000 crores each on June 21, 2018, and July 19, 2018, to maintain durable liquidity.
• This may be done to check the currency's value for fiat currencies and other foreign currencies.

Conclusion

Open market operations are the central bank's monetary policy Monetary policy refers to the steps taken by a country's central bank to control the money supply for economic stability. For example, policymakers manipulate money circulation for increasing employment, GDP, price stability by using tools such as interest rates, reserves, bonds, etc. read more tool to maintain inflation, interest rates, money supply, and liquidity in the economy. The central bank can buy or sell securities under such operations depending on the economic conditions. Permanent measures are generally taken to target inflation and interest rates for the short-term duration. In contrast, temporary measures are typically taken to check liquidity Liquidity is the ease of converting assets or securities into cash. read more in the system for the near-term duration. Whether the general public buys or sells securities impacts the general public and business houses as the loans may get costlier or cheaper, respectively.

Open Market Operations Video

Recommended Articles

This has been a guide to open market operations. Here we discuss how the open market works and the key steps taken by the Central Bank. We also discuss open market operations examples along with their advantages. You may look at these articles below to learn more about Economics.

• What is Market Indicators?
• Fiscal Policy vs Monetary Policy
• Statement of Operations
• Positive Economics

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Source: https://www.wallstreetmojo.com/open-market-operations/

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